In the financial world, market movement dynamics are often intriguing. An interesting roller coaster ride has been seen over the past weeks in the mortgage-backed securities (MBS) sector. Volatility is typically the status quo in these markets, but recent developments have made it even more gripping. Let’s unfold how these market dynamics played out, what linked them together, and what it holds for the future.
To lay the groundwork, mortgage-backed securities are financial instruments that are backed by mortgage loans. The yields of these securities are an integral part of determining mortgage rates. Hence, market volatility has a direct impact on households, commercial institutions, and the banking sector at large. For detailed understanding and the right perspective, it’s crucial to take a step back to the first week of January to see how things started panning out.
In the initial days of 2022, bond yields faced a vigorous selling regime. The news of a faster winding down of bond purchases by the Federal Reserve had made lasting ripples in the market. We know it as the ‘tapering.’
Tapering, in economic parlance, is a gradual reduction of central bank activities to boost the financial markets. Given the financial market is highly sensitive to movements of cash flows, tapering is a significant event. The Federal Reserve’s decision to conclude tapering by March instead of June was seen as an aggressive move.
The bond market’s reaction was swift and rather brutal, with 10-year yields spiking from 1.51% to 1.77% in just two days. Fast forward to the second week of January, bonds found their footing again. The 10-year yields moved back to 1.7%, seemingly an improvement; however, the external factors driving this shift were becoming increasingly complex.
The primary driver behind this was geopolitics, specifically simmering tensions between Russia and Ukraine, turning into a possible military conflict. Such geopolitical situations are always a wild card for market fluctuations. In this case, a potential conflict gave rise to risk aversion in the markets worldwide. As a result, the capital moved from volatile sectors to relatively safer avenues like bonds, driving their yields down.
Market aficionados would refer to this as a ‘flight to quality’ phenomenon, a term indebted to the world of finance. When investors sense significant risks lying ahead, they often shift in favor of less risky investments, which typically includes bonds. But how did the MBS market get along amidst this chaos? Not as smoothly as one might expect.
On the MBS front, Fannie 3.0 coupons, a popular MBS category, began to witness substantial reductions in gains. Through the first week of January, Fannie 3.0s plummeted by almost ⅞ of a point in price.
To understand this discrepancy between bond yields and MBS, we must delve into some esoteric market knowledge. It’s tied to the concept of ‘negative convexity’ in MBS investing. One of the fundamental aspects that makes MBS different from the Bond market is their reaction to market fluctuations.
Negative convexity indicates that MBS prices do not rise as quickly as they fall in response to changes in interest rates. When rates decrease, prematurity risk (the risk of homeowners refinancing mortgages earlier than expected) increases, capping the potential gains for MBS. Conversely, when rates rise, extension risk (the risk of homeowners delaying refinancing) drops, and MBS prices plunge more steeply. So, MBS prices may not improve substantially even if Bonds are in a rally, explaining the underperformance during the volatile trading periods.
This feeds into another unique characteristic of the MBS market—the ‘roll.’ Simply put, it’s the difference in price between settling a trade immediately or a month from now. The extent of this difference is impacted by many supply-demand dynamics and is typically predictable. However, due to significant recent market fluctuations, the predictability of the roll was thrown off.
To get an idea of the issue, imagine a casino scenario. When a casino operates under normal conditions, the house always has its edge. But if the patrons begin to play unpredictably due to some reason, the house would lose its edge, causing confusion and havoc. Similarly, the unpredictability in the MBS market disrupted normal operations, causing a mess.
Fast forward to the third week of January, past was seemingly becoming prologue, with a similar rollercoaster ride seen during the first week. Fears of Fed hiking rates, compounded by developments in geopolitical scenarios, were still casting a cloud of uncertainty over the markets. The 10-year yields stepped back from the brink, returning to levels below those seen at the start of the month.
Although there remains a risk of a return to the higher volatility seen in early January, the calmer conditions do allow for a return to semi-normalcy. However, the market is far from out of the woods. Corporations and households need to brace themselves for the fact that mortgage rates could still end up higher by the end of the quarter.
In sum, this twist and twirl in the MBS market reflect just how directly and tangibly global events can shape and swing financial markets. It’s not just the big, headline-grabbing moves that matter. As we’ve seen, subtle, esoteric factors can dramatically shift market dynamics on any given day. Lining up all these insights, it’s important to continue gauging the directions and undercurrents of the MBS market.